Notz Stucki Investment Conference – Notes 27 06 2017

So far this year the optimists have been proven right, as stock markets have advanced steadily. This is supported by evidence that the world economy is in better shape, and is in a more predictable and sustainable condition than it has been for ten years. While this has been increasingly evident in economic statistics over the past year it has been overshadowed by political turmoil, particularly Brexit and Trump’s election, which could have had a serious impact on world growth if it had been followed by similar results in Europe’s elections this year. The Dutch and French elections conclusively rejected the populist surge, and now financial markets have a reassuring combination of stable economic growth and political calm. Where are the best opportunities to take advantage of this?

Anatole Kaletsky, Gavekal

It is clear that the US has discounted this brighter outlook the most, largely because their recovery was well ahead of the rest of the world. From 2010 to 2014 the US economic expansion was driven by QE. However, since that ended interest rates have been rising slowly, yet the economy has still maintained modest growth. Employment has grown at a rate of two hundred thousand jobs a month with the odd soft patch, and US private sector GDP has been growing 3% p.a. since 2010. There was a danger that Trump’s election would bring a Reaganomics style economic boom which with employment already full could have caused inflation to take off. However, the Trump Administration has become paralysed through some self-inflicted actions, and as it collided with the Congressional process. As a result it seems that it will get little of its agenda through. This is disappointing for cyclical assets, but to the extent that it puts less pressure to raise interest rates and a higher dollar it is helpful for most other assets. From here the US economy should follow a slow self-sustaining expansion. Nonetheless the stock market has largely discounted this story, and as interest rates rise and monetary support is gradually withdrawn the headwinds will build making further advances of the index more difficult. Moreover the US stock market has become very narrow with just a few stocks pushing the index up, which is a sign that the market is not healthy. These market leaders are all technology companies and their profitability is based on monopolistic practices. History has shown at some point these monopolies get broken, or at least reined in. The US bull market is looking mature, and it is worth highlighting that the last four years global stock market performance has been carried almost entirely by the US. Since 2013 the US has surged ahead while the rest of the world’s markets have been almost flat when measured in US dollars (they have done better in local currencies). It looks to be a good time to start to rotate assets elsewhere.

Europe appears the most attractive alternative. The threat of the break-up of the Eurozone has gone, and Europe is reporting much better data, with even Italy improving and Greek debt recently upgraded. The shift in politics from six months ago has been dramatic and this takes away the risk premium that, quite rationally, had been there before. The genuine concern about a political nightmare that Draghi would not have been able to solve has disappeared. Furthermore the ECB continues to pump gargantuan quantities of liquidity into the system; €85bn a month or the equivalent of 200% of net sovereign issuance.

Anatole Kaletsky, Gavekal

The other concern of investors last year, which was the collapse of China’s growth, is also receding. It is clear that China is slowing but if the rate of slowdown is held at 0.5% that still represents considerable economic growth given the large base effect. The concern on China is rather the lack of reform that has taken place, the build-up of debt levels, the signs of increased central planning and poor corporate governance. By virtue of its size these concerns mean that China has become a potential source of instability. When China sneezes the world will catch pneumonia, but that day is a year or two away.

The tremendous positive factor in the world today is the oil price. The fall of the oil price from over $100 to under $50 represents a transfer of two trillion dollars from producers to consumers. This is underwriting the recovery around the world as it releases consumers spending power and allows for more debt repayment. It has the effect of a giant tax cut.

As the global picture becomes one of steady growth everywhere bonds look more and more overvalued, particularly in the US. Policy has been unprecedentedly stimulative, for example in the US real rates have been negative for ten years. The expectation must be that US bond yields will drift higher. However, in Europe and Japan bond yields will probably stay low despite the recovery of their economies because their Central Banks are determined to keep monetary policy loose. The same does not apply to their currencies. The dollar looks extremely overvalued, arguably as overvalued as it has been in the last fifty years, with the exception of the brief peak in the mid 1980’s driven by Reaganomics. The euro looks correspondingly undervalued and but for the expectation of interest rates rising the euro would probably be climbing against the dollar now. But Fed tightening will not be enough to hold the dollar at its current levels. As Europe recovers the euro should recover with it over the next few years.

World growth is solid, and is supported now with a much more constructive political environment. The US has largely discounted this situation but the road map for the rest of the world is one that should follow the US with a lag. Japan is probably about three years behind the US and Europe maybe five years behind. This gives plenty of opportunity for equities in these countries to catch up over the next several years as growth comes through. Care needs to be taken as there are areas of the market that exhibit a high element of speculation; a number of companies are selling on high multiples while their growth is nothing special, and overall equities are not cheap except when compared to very expensive bond markets. However, the better environment in Europe should bolster returns there, though it should be noted that the returns are likely to derive as much from currency gains as stock appreciation.